Making Sense of Capital: Loans, Credit, and Investments
Cars can’t run without fuel -- be it gas or electric. No matter how clean its wheels are, shiny its paint is, or primed its engine’s cylinders are, it can’t run without fuel.
Capital is to business, as fuel is to cars. Without capital, businesses cannot run. They can’t move forward or grow, let alone exist.
In previous blogs, we talked about identifying whether you have enough money to grow your business, and how to allocate funds. In this blog, we’ll outline the different options you have when sourcing and deploying capital:
Small Business Loan
Definition: A small business loan is when a borrower -- or group of borrowers -- borrows a sum of money to fund from a lender to fund their business. This type of loan is based on a set period of time, principal amount, and interest to be repaid.
What it Means: Business owners use both their personal and business financial information to qualify for a loan to fund their business. While varying legal factors influence personal responsibility, business owners can, at times, be personally liable for this type of loan.
Benefit: Business owners can get better interest rates, explore various loan options, and do not sacrifice any ownership of the company.
Drawback: Lenders may require the borrower to put up some type of security or collateral. In the case of a new business, business owners may be putting up personal property at the expense of their business. One of the biggest drawbacks is that small business loans are difficult to obtain and have an extensive application process, often requiring a business plan, financial statements, and other materials.
Definition: SBA loans are a specific type of small business loan. Under the guidelines and requirements set by the SBA, lenders can underwrite small business loans and get them guarunteed by the SBA.
What it Means: By guarunteeing the loan, the SBA reduces risk to its lending partners. This incentivizes lenders to finance more small businesses, and makes more capital accessible to business owners.
Benefit: There’s a variety of benefits depending on the SBA loan type. Benefits vary from lower down payments to competitive rates, and not having to provide collateral to receiving education and support.
Drawback: The requirements for SBA loans are pretty black and white -- you either qualify for their requirements, or you don’t. You have to be willing to confine yourself to their standards.
Lines of Credit
Definition: An agreed upon amount of standing credit, similar to a loan, that a customer can withdraw at anytime. Customers can draw on this line of credit so long as it does not exceed the limit -- just like a personal credit card works. Differing from a loan, LOC’s are only charged interest on the money actually used, not the full amount of their line.
What it Means: Business owners get access to capital when they need it, and only when they need it. This is helpful to cyclical businesses that expand and contract according to market conditions, and growing businesses that need to fund purchase orders or expand operating capital.
Benefit: Lines of Credit are flexible and allow business owners to access capital when they need it, and only when they need it. It can also be beneficial in an emergency or surprise situation.
Drawback: LOC’s are unsecured, which means that interest rates vary with fluctuations in market interest rates. Because of this, borrowers can end up paying high interest rates relative to the amount they borrowed, due to factors outside of their actual business financial standing.
Definition: An angel investor is an individual with a high net worth who provides financial backing to startups and small businesses. Most commonly, angel investors inject an initial, one-time investment to launch a company off the ground. Some may choose to invest multiple times throughout the company’s growth to expand their position in a more proven company.
What it Means: Angel investors are given their namesake for a reason. It seems like something divine came down from the heavens and granted the money no one else would give them. They invest in companies earlier than venture capitalists and fund companies with a lot less information than banks require. They take the chance of investing early, but also get more upside on potential growth.
Benefit: Business owners don’t have any monthly payments, or interest added on top of the principal capital. Angel investors often add more than just money -- they usually offer value in the form of strategic advice and making introductions to their network to propel growth.
Drawback: While there are friends and family and crowd-funding platforms, true angel investors are hard to come by if you do not know someone or have connections. Angel investors have to be accredited investors, which has its set of stipulations and limitations. Business owners have to compete against other aspiring entrepreneurs, and sacrifice equity ownership in their company in exchange for capital.
Definition: Similar to angel investors, venture capital firms invest in early-stage and growing private companies to fuel growth and capture upside potential from that growth. Venture capital firms will open up funds and seek investments from high net worth individuals, pension funds, endowments, corporations, and other institutions. Venture capital firms, in turn, make investment decisions and provide strategic and management advisory to scale invested companies.
What it Means: If a business owner takes venture capital money, it usually comes along with a board seat and the ability to make high-level decisions that impact the company’s trajectory. They inject large sums of money in the hopes to scale so large the underlying company gets acquired by a larger competitor, or cashes out in an Initial Public Offering (IPO).
Benefit: Venture capital funding brings a lot of bang for its buck. Business owners get a team that understands how to successfully grow and scale a business. The large sums of money also quell many business owner cries of needing more staff and marketing dollars, allowing the company to do what it wants -- and needs -- to do without the restraint of capital. The investment also provides a “stamp of approval”, increasing credibility in the marketplace.
Drawback: Venture Capital firms take a significant amount of equity, which in an ideal world, means a smaller piece of a bigger pie. In a not-ideal world, business owners get a smaller piece of the same pie. Business owners will almost certainly cede some level of control and decision-making ability, as the company’s governance needs to account for its goals and desires -- and agenda, too.
Definition: Private equity firms fund themselves similarly to how venture capital firms do. However, their investments span a larger horizon, including corporate buy-outs and take-overs, real estate development, and debt financing. Their goal, like venture capital firms, is to generate returns for itself and shareholders.
What it Means: In the case of funding, private equity firms provide debt financing to companies that cannot qualify for traditional bank lending, but do not want to sacrifice equity.
Benefit: Business owners access capital that otherwise would be unavailable to them in other formats.
Drawback: In the case of a loan, interest rates are usually higher due to the risk taken by the private equity firm. This means business owners are spending more money to access that capital.
Accessing capital comes with its risks and rewards. Over-leveraging can catapult businesses off a cliff and into insolvency, risking bankruptcy, ownership transfer, and unemployment for workers. But not risking anything can mean failing before a business even starts.
When seeking capital, make sure to balance the risks and rewards, conduct detailed due diligence, research all options, and read line-by-line through all contracts and paperwork. Business owners want to ensure they know what they’re getting into before accepting terms.